Net Operating Income Approach MM Proposition I &II

Traditional Approach The traditional approach argues that moderate degree of debt can lower the firm’s overall cost of capital and thereby, increase the firm value. But as debt increases, shareholders perceive higher risk and the cost of equity rises until a point is reached at which the advantage of lower cost of debt is more than offset by more expensive equity.

The traditional approach is known as intermediate approach in between the Net income approach and NOI approach. The cost of overall capital will come down due to the application cheaper source of financing viz Debt financing to some extent, after certain usage, the application of debt will enhance the financial risk of the firm, which will require the share holders to expect additional return nothing but is risk premium.

The risk premium which is expected by the investors will enhance the overall cost of capital. The optimum capital structure "the marginal real cost of debt, defined to include both implicit and explicit will be equal to the real cost of equity. For a debt-equity ratio before that level, the marginal cost of debt would be less than that of equity capital, while beyond that level of leverage, the marginal real cost of debt would exceed that of equity

In considering the most desirable capital structure for a company, the following estimates of the cost of debt and equity capital (after tax) has been made at various levels of debt-equity mix. You are required to determine the optimal debt-equity mix for the company by calculating composite cost of capital.

Debt as % of total capital employed Cost of debt Cost of equity 5 12 10 20 12.5 30 5.5 13 40 6 14 50 6.5 16 60 7

Statement showing the co’s composite cost of capital (after tax) Debt % of total capital employed Kd% Ke% Ko Ko% 5 12 (5*0) + (12*1.00) 10 (5*.10) + (12*.90) 11.3 20 12.5 (5*.20) + (12.5*.80) 11 30 5.5 13 (5.5*.30) + (13*.70) 10.75 40 6 14 (6*.40) + (14*.60) 10.80 50 6.5 16 (6.5*.50) + (16*.50) 11.25 60 7 (7*.60) + (20*.40) 12.20 Optimal debt-equity mix is 30% debt and 70% equity, where the Ko is the least

Problem Compute the equilibrium values and capitalization rates of equity of the company A and B on the basis of following data. Assume that: There is no income tax The equilibrium value of average cost of capital (P) is 8.5% Particulars Company A Company B Total Market value 250 300 Less: Debt 150 Value of equity Expected Net operating income 25 Less: Interest 9 Net Income 16 Ke 10.0% 10.7% Financial Leverage 0.5 Average cost of capital 8.33%

(Equilibrium value orVe)=EBIT/Equilibrium cost of capital = Rs. 25/ (Equilibrium value orVe)=EBIT/Equilibrium cost of capital = Rs.25/.085 =Rs.294.12 Equity Equalization rates for Companies A & B Particulars A B Expected Net operating Income 25 Less: Interest - 9 NI available for Equity 16 Equilibrium cost of capital 8.5% Total value of company 294.12 Less: Market value of debt 150 Market value of equity 144.12 Cost of equity(Ke) = NI/Mkt value of equity 11.1%

MM Theory : No Taxation The debt is less expensive than equity. An increase in debt will increase the Ke. With increase in the levels of debt, there will be higher level of interest payments affecting the cash flow of the company. With increase in the levels of debt, there will be higher level of interest payments affecting the cash flow of the company

MM Approach Without Tax: Proposition I MM’s Proposition I states that the firm’s value is independent of its capital structure. With personal leverage, shareholders can receive exactly the same return, with the same risk, from a levered firm and an unlevered firm. Thus, they will sell shares of the over-priced firm and buy shares of the under-priced firm until the two values equate. This is called arbitrage.

This approach is discussed under the perfect market conditions Securities are divisible infinitely. Investors are allowed to buy and sell securities Investors are rational to access the information No transaction costs involved in the process of the buying and selling of securities

MM hypothesis with corporate Taxation The tax burden on the company will less to the extent of relief available on interest payable on the debt, which makes the Kd cheaper which reduces Ko.

MM’s Proposition II Under current laws in most countries, debt has an important advantage over equity: interest payments on debt are tax deductible, whereas dividend payments and retained earnings are not. Investors in a levered firm receive in the aggregate the unlevered cash flow plus an amount equal to the tax deduction on interest.

MM Proposition III Ko is the cut-off points for all investment decisions. The Ko is completely unaffected by the debt-equity mix. This implies a complete separation of investment and financing decisions of the firm.